Banc of America, joining others, warns on brokers

Cites valuations that actually may not be as attractive as they first appear

By

RileyMcDermid

NEW YORK (MarketWatch) -- Banc of America Securities analysts Tuesday joined a slew of fellow researchers at other firms in cautioning about the brokerage sector's outlook, cutting earnings estimates and warning clients that shares still look richly valued in light of current risk levels.

The analysts cut their second-quarter estimates most dramatically on Lehman Brothers Holdings Inc.
LEH
now forecasting a loss of 50 cents a share compared to its prior projection calling for a 76-cent profit.

They also reduced their estimates on Goldman Sachs Group
GS, +2.50%
to a profit of $3.45 a share from $3.75 previously, and on Morgan Stanley
MS, +2.20%
to a profit of 95 cents a share from $1.40.

"Slowing economic growth and still large balance sheet exposure to residential and commercial mortgages and hung bridges suggest a lackluster, low-visibility environment for the large I-banks through '08," Banc of America's Michael Hecht and Scott Buck wrote in a research note.

Hecht and Buck estimated that the three companies' actual book value could be as much as 20% lower than what their balance sheets currently show.

That means that investors who are valuing the shares of these banks according to historical price-to-book-value ratios could be making a mistake by jumping in to snap up what seem like good bargains on sharply devalued financial stocks.

"Using our adjusted estimate of book value, the group is only 17% below its five-year average and 27% below over 10-years," Hecht wrote. "And looking at trough multiples, based on our price/adjusted book valuation, the group still trades 28% above its five-year trough [price-to-book ratio] and 33% above the 10-year trough."

Several analysts have trimmed earnings estimates and price targets for Wall Street's biggest brokers recently, as fear of further write-downs and worries about a broadening economic slowdown weigh on business.

'Meaningful dislocation'

In the last week, Lehman Brothers analysts slashed their second-quarter profit estimates, based on concerns about future hedging on risky investment. Lehman trimmed its second-quarter profit view for Morgan Stanley to 87 cents a share from $1.31 a share previously, and for Goldman to $3.18 a share from $3.75 a share. See full story

"This past quarter we have seen a meaningful dislocation between cash and derivative prices across several assets classes including commercial mortgages, leveraged loans and corporate debt," Lehman analyst Roger Freeman wrote in a research note. "We believe that the brokers will incur hedging program losses due to this basis risk."

Both Goldman and Morgan Stanley are still rated equal weight by Lehman.

Citigroup analysts, too, last week trimmed their second-quarter earnings estimates for Goldman, Morgan Stanley and Lehman, saying a tough operating environment will weigh on results for the trio of investment houses.

As revised, Citigroup cut its outlook for Goldman Sachs' second-quarter profit to $3.70 a share, putting its forecast in line with the Wall Street consensus pegging earnings at $3.69 a share.

However, Citigroup's analysts revised lower their outlook for Morgan Stanley and Lehman significantly below consensus levels, reducing the former's earnings to 75 cents a share from $1.15 previously and cutting the latter's projected profit to 55 cents a share from 90 cents.

Banc of America shared those concerns Tuesday, saying that for now, they would sit on the sidelines when it comes to the larger investment banks and focus on asset managers as offering solid earning prospects instead.

"We are neutral on the large investment banks and prefer asset managers, given positive operating leverage to above-average organic growth and positively trending equity markets," Hecht wrote in his research note. "While asset managers' valuations are above historical norms by a wider gap than the brokers, we favor names with accelerating growth prospects and potential to expand margins."

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